Secondaries v2.0: The Era of Transformation

Investment Focus

Secondaries v2.0: The Era of Transformation

In 2017, a general partner (“GP”) approached Morgan Stanley Alternative Investment Partners (“AIP”) looking for a solution to an issue faced by an increasing number of GPs. The GP managed a 2004 vintage year fund that was reaching the end of its statutory life and held an unrealized investment with meaningful growth prospects. However, the 2004 fund had no remaining capital to invest in the company and the GP needed more time to fully capitalize on the growth potential of the business. The lead partner remarked, “I have more upside and lower risk with this asset than anything else I can buy in the market right now. Why would I sell it?”

In the secondaries market today, a compelling solution exists for GPs who encounter these situations. AIP refers to these transactions as “transformational secondaries.” This form of GP-led secondary now comprises almost a third of the $74 billion secondary market.1

Transformational secondaries, particularly transactions involving single assets, are compelling because we believe they can provide key benefits beyond those typically associated with traditional limited partner (“LP”) secondaries. In addition to providing a shorter duration, mitigated blind pool risk and purchase price discounts, transformational secondaries seek to maximize the value of unrealized assets by providing opportunistic growth capital, additional time and enhanced alignment with the GP.

Single-asset transactions with high quality GPs, in our view, enable the secondary market investor to more effectively leverage the GP’s intimate knowledge of the underlying asset, to collaborate with the GP in enhancing the value of the asset in its next phase of value creation and to negotiate deal terms that closely align the interests of the GP and the investor. Outside of transformational secondaries, we believe that it is difficult to find transactions with this combination of potential benefits in the secondary markets today.

What are transformational secondaries and why are they attractive?

GPs of private equity funds often find themselves having to manage a multitude of structural obstacles that inhibit their ability to unlock value in certain assets. In our experience, common obstacles include:

Unrealized assets with untapped value potential in a fund that is approaching end of term with existing investors desiring liquidity

Co-investors with different outlooks on certain assets and who are seeking liquidity on a different timeline

Teams being spun-out from captive sources of capital

Need for re-alignment in economic terms between GP and LPs

A challenge that consistently arises for GPs in all of these situations is providing an outcome that works for all stakeholders involved. We believe that transformational secondaries can be a winning solution for the GP of the fund, existing fund LPs and for the new investor.

Transformational secondaries come in many forms, including: fund restructurings, fund recapitalizations, portfolio strip purchases, single-asset solutions and GP spinouts. Some transactions facilitate ways for GPs to hold onto a promising asset while allowing certain LPs to cash out; others allow the GPs to maintain control of assets where additional capital is required. The constant across all of these transaction types is providing LPs with optionality. Structurally, the asset or assets would be moved to a new special purpose vehicle with an extended term that enables these assets to reach harvest maturity. Existing investors would typically have the option to participate in the next phase of value creation of the asset or assets at no change in the economics, and those who desire liquidity can potentially cash out at a fair market price.

The transformational segment of the secondary market has gained significant traction in recent years, as shown in Display 1,2 as a result of its attractiveness in offering a solution to all stakeholders.

DISPLAY 1 GP-Led Transaction Volume By Year ($B)

Key benefits to investors, particularly as it relates to single asset solutions, may include:

HIGH DEGREE OF TRANSPARENCY: Buyers may typically benefit from better access to a GP, company management teams and key company data, allowing for deeper due diligence and improved transparency. This additional access to company management as well as to comprehensive company data is often crucial in providing the buyers with the necessary comfort and confidence to offer the most competitive price to existing investors.

IMPROVED MANAGER ALIGNMENT: Transformational secondaries provide an opportunity to invest with high quality GPs who are well-aligned with new investors through a modification of fund economics and a meaningful commitment of GP capital. Alignment may be improved via one or more of the following mechanisms:

– New and larger than average manager commitments to the restructured fund,

– Re-investment of any accrued carry proceeds,

– Budgeted management fees and/or,

– Higher than average hurdle rates before the manager participates in additional carried interest

We believe it is important to carefully assess a GP’s intent and seek to ensure that GPs are not pursing transformational solutions for short-term gains, but instead because they believe in the long-term potential of the assets.

LIMITED COMPETITION DUE TO COMPLEXITY: Transformational secondaries are highly complex transactions requiring specialized skills and experience to successfully participate in the market. In our view, only a small number of players have the necessary resources and capabilities to pursue these transactions which may result in more attractive pricing and terms.

Where do transformational secondaries exist?

Transformational secondary opportunities exist across the entire spectrum of vintage years. Older vintage funds may hold one or more unrealized companies that are currently performing well, but may have taken longer than expected to create value. The initial investment may have been made during a period of cyclically high valuations or with leverage levels that may have impacted the company’s ability to use cash for growth initiatives. For these reasons and others, assets purchased over the last decade are facing longer holds to achieve a return target. This longer time frame often results in older vintage funds holding assets that need more time to drive a good outcome, but reside within funds which need a structural solution prior to the end of their initial or extended term.

As shown in Display 2,3 there is approximately $249 billion of unrealized NAV in funds that are at least a decade old. Many LPs who invested in these funds are seeking a partial or full liquidity solution for their investment. This already large and diverse market opportunity, which is set against a backdrop of a favorable distribution environment, we believe, is well-positioned for further growth in less benign distribution environments. Transformational secondaries will likely continue to expand as liquidity issues prompt GPs to consider these transaction types as a solution to structural challenges that are likely to become more pronounced.

The opportunity set also exists in newer vintage vehicles. Within the newer vintages, GP spinout transactions have been a common type of transformational solution. In these transactions, a subset of a team leaves an existing asset manager with their assets or the prior captive backer no longer supports the growth of the private equity organization. These spinouts should continue to provide a source of transformational deals in the foreseeable future. Lastly, transformational deals may provide additional growth or acquisition capital to businesses held within a portfolio that is outside its investment period. This dynamic typically did not exist prior to the advent of transformational secondaries and is proving to be an effective tool for newer vintage funds.

DISPLAY 2 Unrealized NAV ($B)

AIP’s approach to this opportunity is unique

The emphasis on single-asset solutions and the application of a multidimensional investment framework to build a resilient portfolio is, in our view, a distinguishing characteristic of an approach to transformational secondaries.

It is important to build a core focus around single-asset solutions with single fund managers as we believe these opportunities allow for greater transparency and due diligence on the underlying portfolio companies as well as providing potentially stronger partnership with the GPs. More importantly, there is often a positive selection bias on the part of the GP in identifying the strongest asset in their remaining portfolio where a transformational secondary opportunity may exist. As buyers, this bias can provide comfort regarding the GP’s level of conviction around the growth prospect for that company. Furthermore, there is a growing prevalence of single-asset transactions in the market from tail-end funds where there may be a dominant unrealized asset within a portfolio, to younger, more recent vintages with an identified single asset requiring a specific solution.

As discussed in the team’s previous whitepaper Where to Next: A Framework for Resilience, AIP has developed a three-pronged investment philosophy centered on selecting assets that can withstand challenging economic environments. The core tenets of this philosophy are (i) identifying efficiency producing businesses with exposure to stable end markets (ii) partnering with highly aligned and specialized investment partners; and (iii) seeking value on the buy with businesses exhibiting high cash flow generation and conservative leverage.

In conclusion, we believe that transformational secondaries are likely to be an increasingly important component of the secondaries market in the future. The opportunity set for transformational secondaries continues to grow and take on various forms as these transactions are used to achieve a widening range of objectives. It is driven by a fundamental need to solve structural limitations that exist in private equity in a way that can be beneficial for all stakeholders. AIP believes that successful navigation of the issues related to single-asset transformational secondaries can offer significant upside potential for investors who take the time and have the patience to complete these structurally complex transactions.

3. Source: Preqin, as of January 2019. The underlying data used to calculate NAVs range between June 2016 and September 2018. Includes only balanced, buyout, growth, turnaround, special situation, natural resources and mezzanine funds that report performance and are managed by GPs based in North America/Europe with geographic focus in those regions. Past Performance is not indicative of future results.

Risk Considerations

Alternative investments are speculative and include a high degree of risk. Investors could lose all, or a substantial amount, of their investment. Alternative instruments are suitable only for long-term investors willing to forgo liquidity and put capital at risk for an indefinite period of time. Alternative investments are typically highly illiquid—there is no secondary market for private funds, and there may be restrictions on redemptions or the assignment or other transfer of investments in private funds. Alternative investments often utilize leverage and other speculative practices that may increase volatility and risk of loss. Financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. The AP Private Markets Team shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary. If such a person considers an investment she/he should always ensure that she/he has satisfied herself/himself that she/he has been properly advised by that financial intermediary about the suitability of an investment.

IMPORTANT INFORMATION

The statements above reflect the opinions and views of Morgan Stanley AIP as of the date hereof and not as of any future date and will not be updated or supplemented. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions.

The information contained herein refers to research, but does not constitute an equity research report and is not from Morgan Stanley Equity Research. The views expressed herein are those of Morgan Stanley Alternative Investment Partners Private Markets (“Morgan Stanley AIP”) as of January 2019 and are subject to change at any time due to changes in market and economic conditions. The views and opinions expressed herein may differ from those of other Morgan Stanley affiliates or businesses. The views and opinions expressed herein are based on matters as they exist as of the date of preparation of this piece and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

These comments are not necessarily representative of the opinions and views of any other Morgan Stanley portfolio manager or of Morgan Stanley as a whole. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. The recipient should bear in mind that past performance is not indicative of future results. Keep in mind that forecasts are inherently limited and should not be relied upon as an indicator of future performance. The views expressed are subject to change based on market, economic and other conditions. They should not be construed as recommendations, but as an illustration of broader economic themes.

Information regarding expected market returns and market outlooks is based on the research, analysis, and opinions of the investment team of Morgan Stanley AIP. These conclusions are speculative in nature, may not come to pass, and are not intended to predict the future of any specific Morgan Stanley investment.

Certain information contained herein constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. There are important differences in how the strategy is carried out in each of the investment vehicles. Your financial professional will be happy to discuss with you the vehicle most appropriate for you given your investment objectives, risk tolerance and investment time horizon. This piece has been prepared solely for informational purposes and is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. The material contained herein has not been based on a consideration of any individual recipient circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, the recipient should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or respect thereto.

By accepting this document, you agree that such document (including any data, analysis, conclusions or other information contained herein provided by the AIP Private Markets Team in connection herewith) may not be reproduced or otherwise shared or distributed to any other persons, in whole or in part, without the prior consent of an AIP Private Markets Team representative.

Persons considering an alternative investment should refer to the specific investment’s offering documentation, which will fully describe the specific risks and considerations associated with such investment.

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors. Funds of funds often have a higher fee structure than single manager funds as a result of the additional layer of fees. Alternative investment funds are often unregulated, are not subject to the same regulatory requirements as mutual funds, and are not required to provide periodic pricing or valuation information to investors. The investment strategies described in the preceding pages may not be suitable for the recipient’s specific circumstances; accordingly, you should consult your own tax, legal or other advisors, both at the outset of any transaction and on an ongoing basis, to determine such suitability.

Risks Relating to Private Equity Investments. Certain funds will typically invest in securities, instruments and assets that are not, and are not expected to become, publicly traded and therefore may require a substantial length of time to realize a return or fully liquidate. The respective general partners cannot provide assurance that they will be able to identify, choose, make or realize investments of the type targeted for their fund, or that such fund will be able to invest fully its committed capital. There can be no assurance that a fund will be able to generate returns for its investors or that returns will be commensurate with the risks of the investments within such fund’s investment objectives. The business of identifying and structuring investments of the types contemplated by these funds is competitive and involves a high degree of uncertainty. In addition to competition from other investors, the availability of investment opportunities generally will be subject to market conditions as well as, in many cases, the prevailing regulatory or political climate. In addition, investments in infrastructure may be subject to a variety of legal risks, including environmental issues, land expropriation and other property-related claims, industrial action and legal action from special interest groups.

This is prepared for sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for the recipient. No investment should be made without proper consideration of the risks and advice from your tax, accounting, legal or other advisors as you deem appropriate.

Morgan Stanley does not render tax advice on tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used with any taxpayer, for the purpose of avoiding penalties which may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. Clients should always consult with a legal or tax advisor for information concerning their individual situation.

DISTRIBUTION

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA, authorised and regulated by the Financial Conduct Authority. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich Branch Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0) 44 588 1074. Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”), (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. In particular, for investment funds that are not authorized or recognized by the MAS, units in such funds are not allowed to be offered to the retail public; any written material issued to persons as aforementioned in connection with an offer is not a prospectus as defined in the SFA and, accordingly, statutory liability under the SFA in relation to the content of prospectuses does not apply, and investors should consider carefully whether the investment is suitable for them. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

This communication is intended to describe an investment strategy. It is not an offer, solicitation or sale in respect of any particular fund or other investment vehicle. Access to this investment strategy may be restricted for certain investors depending on factors such as their location and sophistication. Morgan Stanley is not responsible for the information contained on any third party website or your use or inability to use such site, nor do we guarantee its accuracy or completeness. The terms, conditions, and privacy policy on any third party website may be different from those applicable to your use of any Morgan Stanley website. The opinions expressed by the author of an article written by a third party are solely his/her own and do not necessarily reflect those of Morgan Stanley. The information and data provided by any third party website of publication is as of the date of the material when it was written and is subject to change without notice.

For illustrative purposes only. The statements above reflect the opinions and views of Morgan Stanley AIP Private Markets as of the date hereof and not as of any future date and will not be updated or supplemented. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions. Past performance is not indicative of future results.

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.